This has been a winter of discontent for many energy companies operating in the Bakken and Wattenberg regions, as well as for their shareholders, as operational challenges like floods and high gathering line pressures coupled with wider differentials have hit the stocks. Against that backdrop, small Synergy Resources (SYRG) has been showing some pretty impressive well costs and production rates on its core Wattenberg acreage. With an aggressive drilling program for 2014, a drilling inventory of over 10 years in the Wattenberg, and assets in other areas, Synergy is worth a closer look today.
It's All In Front Of Them
To be sure, Synergy today is a small operator. The company produced 3.2M boepd in the fiscal first quarter (the company is on an August fiscal year) and only began drilling horizontal wells in May of 2013. That means that Synergy has the chance to produce some impressive production growth in the coming years, but it also means that valuation can jump around a lot as analysts and investors readjust their expectations to new information on production rates, decline rates, estimated recoveries, well costs, and so on.
Synergy has a solid asset base from which to begin. The company has acquired about 25,000 acres in the core Wattenberg area in Weld County, and another 25,000 or so in the "extension area" of Weld and Morgan counties. Synergy's acreage is near that of Noble (NYSE:NBL), PDC Energy (NASDAQ:PDCE), and Bonanza Creek (NYSE:BCEI), and Synergy is targeting the same Niobrara B, C, and Codell benches. The company also plans to test its extension area with a vertical test well in the spring that will intersect with the Niobrara, Codell, Greenhorn, D-sand, and J-sand.
Outside of the Wattenberg, Synergy controls 61K net acres in eastern Colorado (Washington and Yuma counties) which is thought to be mostly dry gas acreage). Synergy also has 160K net acres in southwestern Nebraska. There hasn't been much development in this area, but Apache (NYSE:APA) has leased a lot of real estate in Nebraska and Kansas and testing results from Forestar (NYSE:FOR) have indicated that while the area may be challenging (40% success rates and estimated recoveries of less than 50M boe with vertical wells), the low costs suggest strong IRRs. As Synergy's Nebraska leases are long-term (10 years), there's no need to rush - not unlike how Synergy has watched and learned from operators like Anadarko (NYSE:APC), Noble, PDC Energy, and Bonanza Creek in Wattenberg, Synergy can wait and see how other companies' drilling programs work out.
Solid Results, And Good Well Economics So Far
I want to reemphasize that Synergy is in the very early days of its horizontal drilling program. The company is working with Halliburton (NYSE:HAL), but has only completed two pads (Leffler and Renfroe). Even so, the early results look pretty good to me.
It wasn't so long ago that it looked as though Synergy was going to be posting well costs of $4.5 million, in excess of companies like PDC and Bonanza Creek, but actual well costs for Renfroe were about $3.6 million and $3.5 million for Leffler. That's encouraging, particularly as the company used more frac stages than initially planned.
Initial production has been positive, albeit with a caveat or two. Initial 30-day production from Renfroe was quite strong, with 440boe from the B bench and 518 from the Codell, but these wells have seen steeper declines than other nearby wells. Even so, 90-day rates of 321 boe and 376 boe aren't bad at all, particularly with no lift or compression and relative to the well costs. If the production rates and estimated recoveries hold up across additional pads and market valuations stay as they are, Synergy could look appealing to neighbors wanting to shore up and augment their Wattenberg acreage.
It Takes Money To Make Money
With the company's first quarter earnings, management kicked up their capital budget for fiscal 2014 - looking to spend $189 million instead of $159 million. Synergy is now looking to drill 34 operated horizontal wells, five net non-operated wells, and six vertical wells, as well as spend about $30 million on further acquisitions (which would imply another 2K net acres in the core Wattenberg based on the company's last two bolt-on deals). Synergy has the credit facility in place to cover this, so I don't anticipate access to capital being a limiting factor.
At this point in the company's life cycle, "drill, baby, drill" isn't a bad operating strategy. It is true that there is an important link between production growth and debt growth with E&P companies, but that relationship is more relevant for larger, more established companies. Were the initial production rates to fall off or the differential to get really bad, it may make sense to slow the pace of drilling, but the company has only just started exploiting the potential of its acreage.
Operational Challenges Do Have An Impact
The Synergy story is about drilling out its acreage, but that does not make it immune to operational considerations. The Street did not like the greater than 10% production miss in the first quarter, and high gathering line pressures in the Wattenberg have proven to be an ongoing source of trouble. Differentials, too, have expanded and Synergy management guided toward a full-year expectation of $11.50 to $15 per barrel of NYMEX (NYSE:WTI) crude. As a reminder, differentials are basically the end result of a balancing act between production growth in the area, takeaway capacity (pipelines, rail, truck), and refinery capacity/demand.
Estimating The Fair Value
Using EV/EBITDA as a valuation metric for E&P companies is fine, but with the caveat that you have to compare birds of similar feathers. Using EV/EBITDA to compare Synergy to an established company like Anadarko or Noble isn't going to give you a particularly useful result; Synergy is in the early stages of its production curve and just as growth stocks in tech will have seemingly high multiples (because today's earnings are small compared to those expected down the road), the same is true of this company.
Even though net asset value calculations demand a lot of estimates (production/recovery rates, oil prices, lease operating costs, well costs, etc.), it is my preferred approach. I calculate $3 per share in value for the proven acreage. Wattenberg B is worth $4/share in my model, with Codell and C worth $3.50 and $1.50, respectively. I give the company $1/share in value for the Wattenberg extension acreage, but no value today for Nebraska or eastern Colorado. The net result is a NAV fair value of about $12.25 today, using a higher discount rate (12.5%) than most sell-side analysts use (10%). Should the company's estimated recoveries change significantly with further drilling experience (or well costs), that will impact NAV accordingly (higher recoveries = more value). Should differentials stick around $15 indefinitely, the NAV would be lower (by around 12%).
The Bottom Line
With the washout in the E&P space, there are a lot of appealing opportunities. I own Triangle Petroleum (NYSEMKT:TPLM), a Bakken operator, and have written about other Wattenberg operators like Bonanza Creek, PDC Energy, and Noble at other times. I'd definitely shop around and do careful due diligence, but this is increasingly looking like a good opportunity to buy some stocks that got a little too hot in the fall of 2013 at more reasonable valuations.
Disclosure: I am long TPLM, . I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.